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Utilities May Be a Buy When Rates Rise

Higher interest rates may make utility shares more attractive.

Interest-rate-sensitive stocks have suffered since worries about a Federal Reserve easing of its bond-buying program arose. The Utilities Select Sector SPDR ETF dropped nearly 8% from its August high on Fed-taper fears. Though rebounding recently, utilities are still viewed cautiously -- maybe too much so. Investors may want to consider utilities like Ameren (NYSE:AEE) or TECO Energy(UNKNOWN:TE.DL) even in the face of rising rates. Here's why.

Higher rates could make utilities more attractiveWhile utility shares may be negatively affected by higher interest rates, there's a good chance the pain won't last long. A meaningful rise in rates could slow down the economy enough to make power stocks an appealing choice once again.

Such a falloff in the economy might occur because two main drivers of growth are supported by low interest rates. Housing, an economic cornerstone, is obviously rate-sensitive. Signs of slowing, from recent rate advancements, are already appearing in the industry. Domestic oil and gas production, another important economic promoter, is also dependent on low interest rates. Energy exploration and production is a very capital-intensive business.

Since many firms do not yet generate enough cash to cover all of their capital needs, the availability of low-cost credit is necessary to keep the industry expanding. Any significant rise in borrowing costs would likely deter projects, limiting growth in this vital sector.

Signs of an economic slowdown, based on stunted housing gains and reduced energy-project expansion, would quickly end rising interest rate expectations. In that kind of low-growth, interest rate-bound environment, the stable performance and enticing dividend yields of utility stocks would probably look very attractive once more.

A key industry benchmarkOne utility that could be considered an industry benchmark is Consolidated Edison(NYSE:ED). It's one of the nation's largest power suppliers with the New York region being its core service area. Con Ed has an interesting story. Thanks to conservation efforts, the company saw electricity demand decline in the latest quarter. Fortunately, its regulatory revenue agreement excludes changes in electricity sales volumes. This somewhat unique basis helped Con Ed boost profits and seems to provide it with an ability to produce relatively stable results.

Not all on the regulatory side is so positive, however. The company's 2014 customer-rate-increase proposal faces stiff opposition. Con Ed has requested a raise of $375 million but regulators came back with a proposed decrease of $146 million. A judge was recently appointed to settle the differences and a reasonable resolution is hoped for, but one cannot be assured.

Regardless of the regulatory wrangling, and probably due to its steady performance, Con Ed is well regarded on Wall Street. Based on expected 2013 earnings in a range of $3.70 to $3.80 a share, the utility currently trades at around 13.1 times cash earnings of $1.3 billion (cash earnings being net income plus non-cash charges such as depreciation and amortization adjusted for expected capital expenditures.)

A couple of utilities with possible upsideThe most intriguing utilities are those that trade at reasonable valuations and have possible value-improving catalysts. Ameren may qualify. It's making some bold moves that could boost future returns.

The company is currently selling its merchant-generation business. Merchant generation, basically the process of producing electricity, has seen returns crimped by reduced demand and rising production costs. Divesting the business should help Ameren focus on more profitable undertakings.

One such opportunity is the company's 400-mile, $1.1 billion Illinois Rivers transmission project. This development, after recently receiving government approval, could pay off generously. Since improved transmission systems are becoming increasingly needed, they are typically well received and nicely compensated by regulators.

Ameren shares seem justly priced. The company expects 2013 income to be in the $2.00 to $2.10 a share range. Based on that forecast, which implies roughly $768 million in cash earnings, the utility trades at 11.7 times earnings with the possibility of a higher multiple thanks to the sale of the generation business and adoption of the transmission project.

TECO Energy is another interesting case. Having two major subsidiaries, Tampa Electric and TECO Coal, the utility saw a significant drop in its latest quarterly results. Adjusted income fell a disappointing 28% to $65 million. While weather and demand issues contributed, TECO Coal appeared to be the real culprit. It reported a quarterly loss of $1.4 million compared with net income of $17.4 million a year earlier. Lower coal pricing seems to be a continuing concern. Only thanks to tax benefits is the coal business expected to break even in the current quarter.

On the plus side, a recently approved customer rate hike should help ease the pain. The regulatory ruling provides a revenue increase of $57.5 million in 2013 with more to come over the next few years. Benefits from a pending acquisition may also assist. The $950 million purchase of New Mexico Gas will add more than 500,000 accounts to the company's base. TECO will then have more than 1.5 million total regulated utility customers.

TECO's stock price also appears reasonable. With adjusted income-per-share guidance in the range of $0.90 to $1.00 for 2013, the share's trade at roughly 11.3 times, based on about $331 million in cash earnings.

Final thoughtsFears of higher interest rates have pressured utility stocks recently but the anxiety may be overdone. There's a case to be made that higher rates could eventually make utility shares more desirable. If rates do jump, investors may want to consider utilities that are reasonably priced and have potential catalysts. Such purchases, when higher interest rate expectations diminish, could end up proving lucrative.

Author

A dedicated Graham-style value man, Bob bought his first stock in 1986 and though he’s a miserable market timer, longer-term calls let him earn a meager living from his investments. With an MBA and MS in Accounting, Bob relies more on Hetty Green's advice for successful investing: "Buy cheap and sell dear. Act with thrift and shrewdness and be persistent."